The genius of Markowitz’s portfolio theory, unveiled to the world in a 1952 research paper, shines as bright in the 21st century as it did 50 years previous. But it’s debatable if the associated logic and allure of the basic concept is widely understood or practiced in 2008.
Granted, Markowitz himself has partially renounced some of the technical aspects of the original paper. Namely, the idea that one should “optimize” a portfolio solely by analyzing expected returns vis a vis expected volatility (standard deviation) is considered by many to be overly simplistic and in need of revision. In fact, there’s been much progress in bringing more nuance and sophistication to portfolio theory over the past 50 years. There are as many ways to implement a Markowitz-inspired view of portfolio theory as there are stars in the heavens. Yet there’s still value left in the conventional proposition of Markowitz’s portfolio theory, aided and abetted by the capital asset pricing model and the efficient market hypothesis.
In other words, strategic-minded investors could do a lot worse than owning the global capital markets portfolio weighted by the relative market cap weights (and the equivalent for commodities). Such a portfolio has proven to be quite competitive on a risk-adjusted basis with other portfolios, as we’ve discussed from time to time, including here.
The fact that the global markets portfolio, spanning the world’s equity, bond, REIT and commodities markets, can be constructed efficiently and at low cost via ETFs and index mutual funds constitutes real progress in finance, at least by this editor’s reckoning. Why, then, is there so little discussion and analysis of the subject and related opportunities?
Consider, for instance, that of the dozens of ETF-related events this reporter has attended over the last few years the subject of the global markets portfolio rarely comes up. Oh, sure, diversification receives plenty of lip service, but the dialogue is usually pretty thin on the finer points of building and managing a globally diversified portfolio. The preference is almost always one of focusing on the components, i.e., U.S. equities, emerging market equities, commodities, bonds, etc. In fact, there’s ample evidence that the world is even more obsessed with discussing and debating pieces of asset classes, such as value vs. growth stocks, industry analysis, and so on. The big picture–the truly big picture–by comparison is habitually an afterthought, if that.
There’s also a strong affinity for reviewing the technical aspects of ETFs: expense ratios, bid-ask spreads, tax efficiency of ETFs, and so on. Those are all important issues and so they deserve attention and analysis, but it still doesn’t explain the lack of focus on the global markets portfolio.
Perhaps the oversight can be chalked up to self-serving behavior in some corners of finance. The idea that any schlub can now hold a portfolio approximating the global capital and commodities markets, and at a reasonable cost, is nothing short of a financial revolution. And we don’t use the word revolution lightly.
Indeed, John and Jane Doe can own the global capital markets portfolio at an expense ratio of under 50 basis points. What’s more, if they accept modern portfolio theory in strict form, John and Jane can build this portfolio by weighting the various asset classes by their market cap or equivalent weights. In that case, the overall portfolio is “efficient” and so requires no rebalancing going forward, which is to say that no further trading costs are involved. And if the portfolio is built with ETFs, the taxable distributions will be surprisingly low in any given year.
Of course, one could decide that there are reasons for building a portfolio that differs from the asset allocation as per Mr. Market. Ditto for rebalancing, for which there’s a rainbow of strategic options that offer varying degrees of inspiration that managing the portfolio is preferable.
Even so, the case for owning everything is no less compelling. As such, the core debate should focus on: 1) how to initially weight the portfolio across the asset classes; and 2) how to manage the allocations, if at all, across time. Suffice to say, there’s enough work tied to each of those topics to keep even the most ambitious strategist busy on a regular basis.
But let’s not kid ourselves: the world doesn’t work this way. As one example, there’s a certain street that’s famous in finance that’s not particularly interested in promoting the idea of the global markets portfolio. Why? Perhaps it has something to do with the fact that such a radical idea offers precious little opportunity for remuneration compared with the bountiful cash flows generated from business as usual.
It also doesn’t help the case for the global markets portfolio that analyzing the components with an eye on their interaction with the overall portfolio is tougher than it appears. There’s probably not a lot of investors thinking hard about how the purchase of, say, a U.S. equity fund will change the risk-reward outlook for of an existing portfolio. It’s far easier to ponder the prospective returns and risk of U.S. equities in isolation of a larger portfolio.
Clearly, building and managing a global markets portfolio–i.e., thinking and acting strategically–doesn’t come naturally to homo economicus. That’s no surprise, since formal portfolio theory only arrived 50 years ago, despite the fact that the notion of diversifying wealth goes back to at least the 2,000 year-old Talmud.
So, yes, portfolio theory is quite old, which renders it dull and uninspiring in the eyes of many. Of course, that’s true only if you avoid studying the finer points of the global markets portfolio.